Mark Barnett: Rise in UK dividend payout ratio is unsustainable

One question I am being asked a lot at the moment is how the stock market volatility and global events of the past six months have affected my investment strategy. When equity prices move significantly I will always reappraise the positioning of my portfolios but this tends to be more on a rolling 12- to 24-month basis than a reaction to the latest month’s events, however dramatic.

Overall, the events of the summer have not resulted in a major shift in my thinking. The market weakness has been attributed to heightened fears over the impact of the Chinese economic slowdown (see figure 1) and the fragility of elements of its financial system. I have been concerned about the unwinding of the China boom for some years now and remain conscious of the investment implications.

I am still prepared to pay something of a premium for visibility of earnings and dividend growth potential in the current low inflation environment. I think people underestimate how hard it is for many companies to achieve top line sales growth, particularly in US dollar or sterling terms.

The pattern of share price performance in the recent sell-off was, in fact, a continuation of what has been happening for a while. High yielding equities with doubtful dividend cover have become higher yielding as investors have started to worry about dividend cuts.

Resources sectors have continued to underperform the broader market. Companies with Asia related or emerging market business lines have seen share price weakness as they lowered earnings expectations. Companies in the same sector have seen differential share price performance defined by the relative strength of balance sheets.

I am mindful that dividends are being cut in the UK market at a rate last seen in the downturn of 2008-2009 and the aftermath of the 1999-2000 technology boom. The rise in the dividend payout ratio for UK equities looks unsustainable (see figure 2) and I believe it will start declining with a combination of earnings growth and dividend cuts.

The near-term outlook for the UK stock market appears subdued. A number of important external factors have converged in such a way that I do not anticipate a repeat of the benign conditions seen over the past few years. These include: a re-rating of equities to a level whereby, in my opinion, the UK market is no longer is cheap; the weak underlying level of earnings growth in the market; and the declining growth rate of the Chinese economy.

This is a time to be highly selective in portfolio construction. I continue to place a high price on the companies in the market that offer visibility of revenues, profits and cashflows in this low growth world and which are managed for the principal purpose of delivering shareholder value in the form of a sustainable and growing dividend.